Subprime Lending and House Price Volatility
29 Pages Posted: 22 Dec 2008 Last revised: 16 May 2012
Date Written: July 10, 2009
This paper establishes a theoretical and empirical link between the use of aggressive mortgage lending instruments, such as interest only, negative amortization or subprime, mortgages, and the underlying house price volatility. Such instruments, which come into existence through innovation or financial deregulation, allow more borrowing than otherwise would occur in previously affordability constrained markets. Within the context of a model with endogenous rent-buy decision, we demonstrate that the supply of aggressive lending instruments temporarily increases the asset prices in the underlying market because agents find it more attractive to own or because their borrowing constraint is relaxed, or both. This result implies that the availability of aggressive mortgage lending instruments magnifies the real estate cycle and the effects of fundamental demand shocks.
We empirically confirm the predictions of the model using recent subprime origination experience. In particular, we find that counties and cities that receive a high concentration of aggressive lending instruments experience larger price increases and subsequent declines than areas with low concentration of such instruments. This result holds in the presence of various controls and instrumental variables.
Keywords: Real Property, real estate, realty, mortgages, housing prices, aggressive lending, interest only mortgages, negative amortization mortgages, leverage, real estate cycle, housing bubble, price peaks, price declines, negative demand shock
JEL Classification: D12, K11, L85
Suggested Citation: Suggested Citation